Friday, September 26, 2008

The Blame Game

The pundits are wrong. I keep hearing people who frame the bailout as a case of evil investors taking unnecessary gambles, and that society as a whole must now pay for those gambles.

The problem is the opposite. In recent years the market has been driven by an investment paradigm designed to eliminate risk. The investment community has been driven by banks and investment funds trying to get out of risky things like stocks and into secured investments like government backed mortgage securities.

Corporate investment of late has been driven by a new type of investor called a hedge fund. By definition, a hedge fund is a group of people using a mix of equities to hedge their risk. Like other banks, their formulas rely heavily on leveraging government backed mortgages.

Don't you see? The market was not driven by people seeking risky investments! The market was driven by people looking for hedged investments reinsured by the Federal Government. There was a tremendous demand for government backed mortgages to suit the myriad of investment schemes created by risk adverse banks and hedge funds. The mortgage companies responded to and filled that need.

Driven by aversion to risk, leading investors and hedge funds have essentially pulled their equity out of the market and have it locked in trading strategies designed to hedge risk.

The only possible boogeyman in the situation is the frontline mortgage agent who bought the line that they were helping people live the American dream by putting them in a house they could not afford.

It is possible to lay blame for the dotcom bust on the irrational exhuberance of risk takers. The crash of 2008 is a crash driven by aversion to risk.

For example the mark to market accounting rules is causing businesses to fail that actually have a healthy mix of equities but are just suffering from the fact that no-one is currently buying equities.

The reason I've been pounding out blog posts about securities like mortgages and short orders is to show how our financial institutions are building houses of cards on securities which are simply too far divorced from reality to be stable investing tools.

We need to realize that our current problems are driven by the mix of tools on the market. The blame is not with the people.

1 comment:

Reach Upward said...

"Don't you see? The market was not driven by people seeking risky investments! The market was driven by people looking for hedged investments reinsured by the Federal Government."

When I read this, a light suddenly went on in my head. After everything I have studied over the past few months about the crisis we now face, your statement helped cement many pieces of the puzzle together.

Not only were investors driven by an aversion to risk (which has turned out to be a riskier position that accepting straightforward risk), they have been driven by an aversion to paying unnecessary taxes, as I argue in this post.